The Value of Independent Directors: Evidence from Sudden Deaths

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The Value of Independent Directors Evidence
from Sudden Deaths

• Joint with Kasper Meisner Nielsen (CUHK)
• Bang Dang Nguyen, The Chinese University of Hong
  Kong
• Presented at the EFM Symposium, Cambridge, April
  11, 2009

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Research Questions

• Is supposedly good monitoring by independent
  directors translated into increased firm value?
• Conflicting evidence, independent directors are
• Not value-increasing McAvoy et al. (1983),
  Bhagat and Black (1999, 2001), Hermalin and
  Weisbach (1991), Klein (1998)
• Even value-decreasing Agrawal and Knoeber (1996)
• Value-enhancing positive stock reaction to
  nomination of independent directors (Rosenstein
  and Wyatt (1990)) positive correlation between
  fraction of outside directors and accounting
  performance (Core, Holthausen and Lacrker (1999))

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Research Questions

• Why inconclusive insights?
• Endogenous boards (Hermalin and Weisbach (2003))
• Endogenous association between board composition
  and firm performance or firm value
• Board events hardly random, confounding with
  other news i.e. CEO turnover coinciding with
  earning forecast adjustments.
• Issues with performance and firm value measures
• Majority of papers uses MB, Tobins Q, accounting
  measures
• High risk of endogeneity for those metrics
• Independent directors do not contribute to firm
  value
• Fama and Jensen (1983) inside directors command
  superior information Shivsadani and Yermack
  (1999) directors nominated on board by CEOs
• Some hints from popular press, rubber stamp men

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Research Questions

• Are independent directors good for firm value?
• Solutions using exogenous events on directors
• Johnson, Magee, Nagarajan and Newman (1985)
• 53 executive deaths from 1971 to 1982
• Positive stock price reaction to the death of
  founder-CEOs and negative reaction to
  professional CEOs
• How do the market react to sudden deaths of
  independent, gray, and inside directors?
• Does independence matter?
• What are the determinants of contributions of
  independent directors to firm value?
• Independence? Expertise? Monitoring and advisory
  needs?

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Hypotheses

• If an independent director efficiently monitors
  and/or provide the managers with pertinent
  advice, firm value should be reduced when he dies
  suddenly.
• The potential contributions of independent
  directors to firm value depend on their
  independence and expertise, as well as on the
  firm monitoring and advisory needs

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Principal Findings

• Following the death of an independent director,
  stock price drops by almost 1 on average
• Significant and negative CARs firm value reduced
  by 40 million
• No significant stock price reaction for other
  directors
• Independence matters and is valuable
• Markets react less negatively when independent
  directors hold long tenure, and are appointed
  after the CEO
• Results hold when controlling for
  director-invariant variation (e.g. ability,
  experience, and skills) using a fixed-effect
  approach
• Value of independent directors is lower in
  complex and opaque firms where monitoring is less
  effective

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Sample Selection

• News search on deaths of corporate directors
• From January 1, 1994 to December 31, 2007
• Sources Factiva, Lexis-Nexis, SEC Edgar
• Keyword search terms
• Broad and sophisticated search windows
• Directors (board member, chairman director)
• Death (deceased, died, passed away, etc.)
• Gross-sample of 772 deceased directors
• Detailed follow-up search to determine cause of
  death
• Director name search in a one-year window around
  the death
• Final sample
• 229 directors who suddenly died, and who hold 279
  directorships

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Table ICause of Director Deaths
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Event Definition

• Definition of sudden deaths
• Oxford English Dictionary
• Sudden death a noun means of deciding the winner
  in a tied match, in which play continues and the
  winner is the first side or player to score
• Medical definitions
• Sudden death an unexpected and nontraumatic
  death that occurs instantaneously or within a few
  hours of an abrupt change in the person's
  previous clinical state American Academy of
  Pediatrics
• Example sudden cardiac death (SDC) is defined as
  a nontraumatic, nonviolent, unexpected event
  resulting from sudden cardiac arrest within 6
  hours of a previously witnessed state of normal
  health American Academy of Pediatrics

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Event Definition

• We follow the medial definition whenever possible
• Our definition includes
• Strokes, heart attach where death occurs within
  24 hours
• Accidents with instantaneous death
• Deaths reported as sudden and unexpected but
  actual cause of death unreported
• Our definition excludes
• Reported declining health prior to the death
• Brief illness, cancer, declining health, etc.
• Complications of a stroke or heart attack, timing
  unknown
• Suicides (5 cases)

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Table ICause of Director Deaths
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Prominent Examples

• Accidents account for 45 out of 229 cases
• 20 airplane/helicopter crashes
• 15 traffic accidents
• 5 fall incidents accident during polo game
• 2 drowned while swimming / snorkelling on
  vacation
• 2 murdered carjacking, arson (fire)
• 1 died from a shooting incident during a hunting
  trip
• Individual cases
• Jerry R. Junkins, independent director of P G
  heart attack during business trip, May 29, 1996
• James Richard Cantalupo, CEO and Chairman of
  McDonalds (Inside) heart attack while attending
  convention, April 19, 2004
• Susan T. Buffet, gray director of Berkshire
  Hathaway stroke, July 28, 2004
• John T. Walton, inside director of Wal-Mart
  ultralight aircraft crash, June 27, 2005
• Bruce R. Kennedy, gray director of Alaska
  Airways plane crash, June 28, 2007

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2. CAR Around Sudden Deaths

• Event windows
• From day-1 to 0 from day -1 to 1 from day -1
  to 2
• Cumulative abnormal returns (CARs)
• Market model estimated in a pre-event window from
  day -300 to -46
• Table V
• Negative CARs for the pooled sample, but not
  significant
• Negative and significant CARs for independent
  directors firm value reduced by 0.96 during the
  (-1 2) window
• No consistent and significant CARs for gray or
  inside directors

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Table V CARs Arounds Sudden Deaths
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3. Independence and Stock Price Reaction (1)

• If independence matters market response to
  unexpected deaths varies with the degree of
  independence
• Cross-sectional regressions of price reaction on
  proxies for the degree of independence
• Event window from -1 to 2
• WLS regressions market capitalization used to
  weight stock price
• Proxies for degree of independence of directors
• Absolute tenure of director (Hermalin, Weisbach
  (1998), Carter and Lorsch (2004))
• Relative tenure of independent director in
  comparison to the CEO. (Shivsadani and Yermack
  (1999)). Rational CEOs might be involved in the
  selection of directors
• Control variables firm size, firm age, director
  age, industries

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3. Independence and Stock Price Reaction (2)

• Independence is valuable
• Stock prices react less negatively when the
  independent director has long tenure or when
  appointed to the board after the CEO
• Stock price drops by -2.69 and only by -1.16
  following the death of an independent director
  with one year and ten year of tenure respectively
• If tenure over 17 years stock price reaction
  becomes positive

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Table VI Independence and Stock Price Reaction
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4. Independence in Crucial Board Functions

• Independent directors assume the critical
  functions where insiders have potential conflicts
  of interest
• The SOX (2002) chairmen and members of audit
  committees must be independent and have
  competence in accounting and auditing
• Outside directors occupy important board
  committees audit, nomination, compensation
• If crucial board functions valuable, stock price
  react more negatively when the independent
  chairmen or members of such committees suddenly
  die
• Table VII Audit Committee seems to be the most
  important body in boards No effect on
  Nomination, Compensation, Separation between
  Chairman and CEO
• Shivsadani and Yermack (1999) explanation

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Table VII Independence in Crucial Board
Functions
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5. Isolating Independence from Ability and Skills

• Negative stock price reaction might be due to
  independent directors being more skillful than
  inside or gray directors
• Measurable and observable proxies for skills,
  mostly related to educational backgrounds
• Education 96 of all directors hold a bachelor
  degree, 11 a MBA degree, 11 a PhD degree
• Table VIII
• Column (1) education has little explanative
  power
• Columns (3), (4) fixed effect regressions,
  controlling for any director-invariant
  heterogeneity
• Independence is truly valuable

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Table VIII Isolating Independence from Ability
and Skills
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5. Monitoring and Advisory Needs, and Value of
Independence

• Independent directors supposed to both monitor
  and provide advice to the managers
• Conjecture price reaction less negative in firms
  where effective monitoring is more difficult, and
  whenever advice requires firm-specific knowledge
• Proxies for monitoring and advisory needs based
  on level of intangible assets (Opacity) and
  number of business segments (Complexity)
• Table IX independent directors less effective
  (i.e. less valuable) when firms are more opaque
  and more complex

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Table IX Monitoring and Advisory Needs, and
Value of Independence
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Summary

• Paper to provide direct evidence on
  value-enhancing independent directors
• Firm value reduced by 1 after sudden death
• No significant reaction to the death for inside
  or gray directors
• Independence is valuable
• Tenure and appointment before the CEO are
  determinants
• Independence is more valuable in Audit Committees
• Firm monitoring and advisory needs affect the
  value of independent directors